BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 23

3. Economic and policy drivers of liquid biofuels

Agriculture both supplies and demands From the point of view of an individual energy; hence, markets in both sectors have farmer, it is unimportant what end use always been linked. The nature and strength a prospective buyer has in mind for the of these linkages have changed over the crop. Farmers will sell to an ethanol or years, but agricultural and energy markets biodiesel processor if the price they receive have always adjusted to each other, with is higher than they could obtain from a output and consumption rising or falling in food processor or a feeding operation. If response to changing relative prices. Rapidly the price of biofuels is high enough, it will increasing demand for liquid biofuels is bid agricultural commodities away from now tying agriculture and energy more other uses. Because energy markets are closely than ever. However, policy plays an large relative to agricultural markets, a influential role in defining the linkages small change in energy demand can imply between them. Many countries intervene a large change in demand for agricultural in both markets through a range of policy feedstocks. Therefore crude oil prices will measures aimed at addressing a diverse drive biofuel prices and, in turn, influence range of goals. This chapter addresses agricultural commodity prices. the fundamental economic relationships The close link between crude oil prices among agriculture, energy and biofuels. and agricultural prices, mediated by It also reviews the policies being pursued to biofuel demand, in fact establishes a floor promote biofuels and discusses the way in and a ceiling for prices of agricultural which they affect the relationship between commodities – determined by crude oil prices agricultural and energy markets. (FAO, 2006a). When fossil fuel prices reach or exceed the cost of producing substitute biofuels, the energy market creates demand Biofuel markets and policies for agricultural products. If the demand for energy is high relative to markets for A discussion of the economics of liquid agricultural commodities and agricultural biofuels must start from the allocation biofuel feedstocks are competitive in the of resources among competing uses in energy market, this will create a floor price the energy and agriculture sectors. This effect for agricultural products determined competition occurs at several levels. In by fossil fuel prices. At the same time, energy markets, liquid biofuels such as however, agricultural prices cannot increase ethanol and biodiesel are direct competitors faster than energy prices or they will price with petroleum-based petrol and diesel. themselves out of the energy market. Thus, Policies such as mandated blending of as energy markets are very large compared biofuels with petrol and diesel, subsidies with agricultural markets, agricultural prices and tax incentives can encourage biofuel will tend to be driven by energy prices. use, while technical constraints such as a In practice, the link between energy lack of vehicles that run on biofuel blends and agricultural commodity prices may be can discourage their use. Leaving aside such less close and immediate than in theory, factors for the moment, biofuels and fossil at least until biofuel markets become fuels compete on the basis of their energy sufficiently developed. In the short run, a content, and their prices generally move number of constraints limit the capacity of together. the biofuel sector to respond to changes in In agricultural markets, biofuel processors relative prices of fossil fuels and agricultural compete directly with food processors and commodities, for example bottlenecks animal-feeding operations for commodities. in distribution, technical problems in 24 THE STATE OF FOOD AND AGRICULTURE 2008

BOX 3 Biofuel policies in Brazil

Around 45 percent of all energy development of new plantations and a consumed in Brazil comes from renewable fleet of purely ethanol-fuelled vehicles. A sources, reflecting the combined use of series of tax and financial incentives was hydroelectricity (14.5 percent) and biomass introduced. The programme induced a (30.1 percent); the use of sugar cane in the strong response, with ethanol production internal renewable energy supply in 2006 rising rapidly along with the number of represented 32.2 percent of renewable vehicles running exclusively on ethanol. energy and 14.5 percent of total internal Subsidies provided through the energy supply (GBEP, 2007). programme were intended to be Brazil has been a pioneer in national temporary, as high oil prices were regulatory efforts for the bioenergy expected to make ethanol competitive sector and has accumulated significant with petrol in the long run. However, experience and expertise in the area of as international oil prices fell in 1986, biofuels, particularly concerning the use of the elimination of subsidies became ethanol as a transport fuel. The Brazilian problematic. In addition, rising sugar experience of using ethanol as a petrol prices led to scarcity of ethanol, and in additive dates back to the 1920s, but it 1989 severe shortages in some of the was only in 1931 that fuel produced from main consuming centres undermined the sugar cane officially began to be blended credibility of the programme. with petrol. In 1975, following the first The period from 1989 to 2000 was oil crisis, the Government launched the characterized by the dismantling of the National Ethanol Programme (ProAlcool), set of government economic incentives creating the conditions for large-scale for the programme as part of a broader development of the sugar and ethanol deregulation that affected Brazil’s entire industry. The programme was aimed at fuel supply system. In 1990, the Sugar and reducing energy imports and fostering Ethanol Institute, which had regulated the energy independence. Its main goals were Brazilian sugar and ethanol industry for to introduce into the market a mixture over six decades, was extinguished, and of petrol and anhydrous ethanol and to the planning and implementation of the provide incentives for the development industry’s production, distribution and of vehicles that were fuelled exclusively sales activities were gradually transferred with hydrated ethanol. Following the to the private sector. With the end of the second major oil shock, in 1979, a more subsidies, the use of hydrated ethanol as ambitious and comprehensive programme fuel diminished drastically. However, the was implemented, promoting the mixture of anhydrous ethanol with petrol

transportation and blending systems or capable of running on ethanol–petrol blends inadequate plant capacity for conversion of and a national distribution network for feedstocks. The more flexibly demand and ethanol (FAO, 2006a). supply can respond to changing price signals, While agricultural feedstocks compete with the more closely prices on energy and fossil fuels on the energy market, agricultural agricultural markets will be linked. Today, the crops also compete with each other for Brazilian sugar-cane ethanol market is the productive resources. For example, a given most developed and most closely integrated plot of land can be used to grow maize for with energy markets. Contributory factors ethanol or wheat for bread. When biofuel include the existence of a large number of demand bids up the prices of commodities sugar mills able to produce either sugar or used as biofuel feedstock, this tends to bid ethanol, highly efficient energy conversion up the prices of all agricultural commodities systems with co-generation of ethanol and that rely on the same resource base. For electricity, a large share of flex-fuel vehicles this reason, producing biofuels from non- BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 25

was boosted with the introduction in 1993 to be accomplished by 2008 and 2013, of a mandated blending requirement respectively. Reflecting social inclusion and specifying that 22 percent of anhydrous regional development concerns, a system ethanol must be added to all petrol of tax incentives was established for the distributed at retail petrol stations. The production of raw materials for biodiesel blending requirement is still in place on small family farms in the north and today, with the Inter-Ministerial Board northeast regions of Brazil. Under a for Sugar and Ethanol establishing the special scheme, the “Social Fuel Seal” (Selo required percentage, which can range Combustível Social) programme, biodiesel from 20 to 25 percent. producers who buy feedstocks from small The most recent phase of the Brazilian family farms in poor regions pay less ethanol experience began in 2000 with federal income tax and can access finance the revitalization of ethanol fuel and from the Brazilian Development Bank. The was marked by the liberalization of farmers are organized into cooperatives prices in the industry in 2002. Ethanol and receive training from extension exports increased further as a result workers. of high oil prices in the world market. Current bioenergy policies in Brazil The dynamics of the sugar and ethanol are guided by the Federal Government’s industry began to depend much more on Agroenergy Policy Guidelines, prepared market mechanisms, particularly in the by an interministerial team. Linked to the international markets. The industry has overall policy of the Federal Government, made significant investments, expanding the Ministry of Agriculture, Livestock and production and modernizing technologies. Food Supply has prepared a programme to An important factor in domestic market meet the bioenergy needs of the country. development in recent years has been the The goal of the Brazilian Agroenergy investment of the automobile industry in Plan 2006–2011 is to ensure the bi-fuel or dual-fuel alcohol–petrol cars, competitiveness of Brazilian agribusiness also referred to as flex-fuel vehicles, which and support specific public policies, such as are able to run on a blend of petrol and social inclusion, regional development and ethanol. environmental sustainability. Biodiesel, by contrast, is still an infant industry in Brazil, and biodiesel policies are much more recent. The biodiesel law of 2005 established minimum blending Sources: based on GBEP, 2007, and Buarque de requirements of 2 percent and 5 percent Hollanda and Poole, 2001.

food crops will not necessarily eliminate the of developing countries – are promoting competition between food and fuel; if the biofuels for three main reasons: strategic same land and other resources are needed concerns over energy security and energy for both food and biofuel feedstock crops, prices, concerns over climate change, and their prices will move together even if the agricultural support considerations. feedstock crop cannot be used for food. One justification made for providing policy Given current technologies, the costs of support to a new sector is that it is needed producing crops and converting them to to overcome the initial costs of technological ethanol or biodiesel are too high in many innovation and market development locations for biofuels to compete with fossil required to enable a sector to become fuels on a commercial basis without active competitive. This is the “infant industry” government support to promote their argument for subsidies. But subsidies for development and subsidize their use. Many a sector that cannot ultimately achieve countries – including a growing number economic viability are not sustainable and 26 THE STATE OF FOOD AND AGRICULTURE 2008

may serve simply to transfer wealth from one the incentive to identify and promote group to another while imposing costs on alternative sources of energy for transport, the economy as a whole. heating and power generation. Strong Subsidies can also be justified when demand from rapidly growing developing the social benefits of developing a sector countries – especially China and India – is outweigh the private economic costs. This adding to concerns over future energy prices may be the case, for example, if liquid and supplies. Bioenergy is seen as one means biofuels generate social benefits in the form of diversifying sources of energy supply and of lower carbon emissions, greater energy reducing dependency on a small number security or revitalized rural areas. Such policy of exporters. Liquid biofuels represent the interventions entail costs, however, and their main alternative source that can supply the consequences are not always as intended. transport sector, which is overwhelmingly These costs include the direct budgetary costs, dependent on oil, without more radical borne by taxpayers, and market costs, borne changes to current transport technologies by consumers, and involve the redistribution and policies. of resources towards the favoured sector. The second important factor driving Distributional effects can extend beyond the bioenergy policies is the increasing concern country implementing the policy to have about human-induced climate change, an international dimension – just as the as the evidence of rising temperatures agricultural support and protection policies and their anthropic origin becomes ever of many OECD countries have complex more compelling. Few now dispute the impacts on producers and consumers in need to take action to reduce greenhouse other countries. In addition, because policy gas emissions, and many countries are interventions divert resources from other incorporating bioenergy as a key element social and private investments, they often in their efforts to mitigate climate change. have indirect opportunity costs. In some Bioenergy has been perceived as offering cases, other policy interventions that target significant potential for emission reductions, the stated objectives of the biofuel policies relative to petroleum-based fuels, in more directly could be less costly and more electricity, heating and transportation, effective. although actual net impacts on greenhouse gas emissions may vary significantly depending on factors such as land-use Underlying objectives of biofuel change, feedstock type and related policies agricultural practices, conversion technology and end use. Indeed, recent analyses suggest As noted above, several countries have that large-scale expansion of biofuel introduced policies promoting the production could cause a net increase in development of liquid biofuels. High emissions. and volatile petroleum prices, increased While climate-change concerns have awareness of fossil fuels’ contribution to been among the strongest incentives for global climate change and the desire to promoting bioenergy development, other promote economic revitalization in rural environmental concerns have also played a areas are the most commonly expressed role – not least the wish to reduce urban air reasons underlying these policies (FAO, pollution. Burning biomass using modern 2007b). technologies or using liquid biofuels in Secure access to energy supplies is a engines may reduce emissions of regulated longstanding concern in many countries. air pollutants relative to fossil fuel use. Also, Reducing vulnerability to price volatility and the generation of energy from residues and supply disruptions has been an objective wastes, such as the biodegradable parts behind the energy policies of many OECD of municipal solid waste, represents an countries for several decades, and many environmentally friendly means for their developing countries are equally concerned disposal. The implications of liquid biofuel about their dependence on imported production and use for the environment, sources of energy. The recent increases in including greenhouse gas emissions, are prices, mainly of oil, have strengthened discussed further in Chapter 5. BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 27

Supporting the farm sector and farm policy instruments and types of related incomes has been a key – if not the most support applied at different stages may have important – driving factor behind biofuel very different market impacts. Generally, policies in several developed countries. policies and support directly linked to In countries with heavily subsidized farm levels of production and consumption are sectors, the revitalization of agriculture considered as having the most significant through its role as provider of bioenergy market-distorting effects, while support to feedstocks has been widely viewed research and development is likely to be the as a solution to the twin problems of least distorting. oversupply of agricultural produce and declining global market opportunities. The Agricultural policies possibility of boosting farm incomes while Agricultural and forestry policies that predate reducing income support and subsidies the liquid biofuels era have had a strong has considerable appeal for policy-makers influence on the bioenergy industry. Indeed, (although the latter part of this strategy agricultural subsidies and price support has been difficult to achieve). While several mechanisms directly affect both production OECD countries, particularly in Europe and levels and prices of first-generation biofuel North America, have long embraced the feedstocks and feedstock production potential of biofuels to support agriculture, systems and methods. Most OECD countries an increasing number of developing have applied policies of subsidization and countries also claim rural development – protection in agriculture, which international along with energy security – objectives for trade negotiations within the framework their biofuel policies (FAO, 2007b). of the World Trade Organization (WTO) have not succeeded in eliminating, although some discipline on agricultural policies and Policy measures affecting biofuel agricultural protection has been introduced. development Such policies have had significant implications for agricultural trade and geographic Biofuel development is influenced by a patterns of agricultural production at the wide range of national policies in multiple international level, as they will for the sectors, including agriculture, energy, production of biofuel feedstocks. transport, environment and trade, as well as broader policies affecting the overall Blending mandates “enabling environment” for business and Quantitative targets are key drivers in the investment. Policies applied to bioenergy, development and growth of most modern particularly liquid biofuels, significantly bioenergy industries, especially liquid influence the profitability of biofuel biofuels for transport, where blending production. Identifying the relevant policies mandates are increasingly imposed. Table 4 and quantifying their impact in specific cases summarizes the current voluntary and is difficult because of the variety of policy mandatory blending requirements for liquid instruments and ways they are applied; biofuels in the G8+5 countries,6 although it however, they have generally translated into should be noted that policies in this area are (sometimes very significant) subsidies aimed in rapid evolution. at supporting biofuels and influencing the financial attractiveness of their production, Subsidies and support trade and use. Support to distribution and use are key policy Subsidies can affect the sector at different components in most countries that promote stages. Figure 8, adapted from the Global the use of biofuels. Several countries are Subsidies Initiative (Steenblik, 2007), shows subsidizing or mandating investments the various points in the biofuel supply chain in infrastructure for biofuel storage, where direct and indirect policy measures can provide support for the sector. Some of 6 The G8+5 group comprises the G8 countries (Canada, these factors are interrelated, and assigning France, Germany, Italy, Japan, the Russian Federation, the United Kingdom and the United States of America), plus policies to one category or another may be the five major emerging economies (Brazil, China, India, somewhat artificial in practice. Different Mexico and South Africa). 28 THE STATE OF FOOD AND AGRICULTURE 2008

FIGURE 8 Support provided at different points in the biofuel supply chain

Support to inputs

Fertilizer, irrigation and other input subsidies General energy RESOURCES and water-pricing policies Land-tenure policies … PRODUCTION Production support

Domestic agricultural subsidies Farm income support FEEDSTOCKS Trade policies General support to agriculture

PROCESSING Processing and marketing support

Production-linked payments Tax credits, incentives and exemptions BIOFUELS Mandated use requirements Trade policies Subsidies for capital investment

CONSUMPTION Support to consumption

Subsidies for purchase of biofuels and co-products Tax exemptions END USE (e.g. road tax) Subsidies for flex-fuel vehicle purchase

Source: adapted from Steenblik, 2007.

transportation and use, most of it directed Tariffs towards ethanol, which normally requires Tariffs on biofuels are widely used to protect major investments in equipment. Such domestic agriculture and biofuel industries, support is often justified on the grounds that support domestic prices of biofuels greater use of ethanol and expansion of the and provide an incentive for domestic market for it will not occur until sufficient production. The major ethanol producers, distribution infrastructure and sales points with the exception of Brazil, apply significant are in place. Flex-fuel vehicles, designed to MFN (most-favoured nation) tariffs (see use higher-percentage blends of ethanol Table 5). However, there are several and petrol than ordinary vehicles, are also exceptions to the MFN rates and tariff quotas actively promoted by many governments, for in place. Generally, lower tariff rates tend to example through reduced registration fees apply to biodiesel. and road taxes. While most petrol-powered cars built in the OECD countries can run Tax incentives on blends with an ethanol content of up While tariffs are used to stimulate domestic to 10 percent, and some up to 20 percent, production and protect domestic producers, flex-fuel vehicles can use any blend up to tax exemptions represent a means for 85 percent of ethanol. stimulating demand for biofuels. Tax BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 29

TABLE 4 Voluntary and mandatory bioenergy targets for transport fuels in G8+5 countries

COUNTRY/COUNTRY TARGETS1 GROUPING

Mandatory blend of 20–25 percent anhydrous ethanol with petrol; minimum blending of 3 percent biodiesel to Brazil diesel by July 2008 and 5 percent (B5) by end of 2010

Canada 5 percent renewable content in petrol by 2010 and 2 percent renewable content in diesel fuel by 2012

China 15 percent of transport energy needs through use of biofuels by 2020

France 5.75 percent by 2008, 7 percent by 2010, 10 percent by 2015 (V), 10 percent by 2020 (M = EU target)

Germany 6.75 percent by 2010, set to rise to 8 percent by 2015, 10 percent by 2020 (M = EU target)

India Proposed blending mandates of 5–10 percent for ethanol and 20 percent for biodiesel

Italy 5.75 percent by 2010 (M), 10 percent by 2020 (M = EU target)

Japan 500 000 kilolitres, as converted to crude oil, by 2010 (V)

Mexico Targets under consideration

Russian Federation No targets

South Africa Up to 8 percent by 2006 (V) (10 percent target under consideration)

United Kingdom 5 percent biofuels by 2010 (M), 10 percent by 2020 (M = EU target)

United States of 9 billion gallons by 2008, rising to 36 billion by 2022 (M). Of the 36 billion gallons, America 21 billion to be from advanced biofuels (of which 16 billion from cellulosic biofuels)

European Union 10 percent by 2020 (M proposed by EU Commission in January 2008)

1 M = mandatory; V = voluntary. Sources: GBEP, 2007, updated with information from the United States Department of Agriculture (USDA, 2008a), the Renewable Fuels Association (RFA, 2008) and written communication from the EU Commission and Professor Ricardo Abramovay, University of São Paulo, Brazil.

TABLE 5 Applied tariffs on ethanol in selected countries

Country/Country Applied MFN tariff At pre-tariff unit value of US$0.50/litre Exceptions/Comments grouping

Local currency Ad valorem equivalent Specific-rate equivalent or ad valorem rate (Percentage) (US$/litre)

United States of America, Australia 5 percent + A$0.38143/litre 51 0.34 New Zealand

From 20 percent Brazil 0 percent 0 0.00 in March 2006

Canada Can$0.0492/litre 9 0.047 FTA partners

Switzerland SwF35/100 kg 46 0.232 EU, GSP

United States 2.5 percent + US$0.54/gallon 28 0.138 FTA partners, CBI partners of America

European Union €0.192/litre 52 0.26 EFTA, GSP

Notes: Ethanol is classified for trade purposes as HS 2207.10, undenatured ethyl alcohol. Tariffs indicated are rates as of 1 January 2007. MFN = most-favoured nation; FTA = Free Trade Association; EFTA = European Free Trade Association; GSP = Generalised System of Preferences; CBI = Caribbean Basin Initiative. Source: Steenblik, 2007. 30 THE STATE OF FOOD AND AGRICULTURE 2008

BOX 4 Biofuel policies in the United States of America

The production of ethanol from maize the Volumetric Ethanol Excise Tax Credit currently dominates United States biofuel (VEETC), a tax credit of 51 cents per gallon production, with production levels of of ethanol for blenders and retailers. The 30 billion litres in 2007, followed by VEETC was extended by the 2005 Energy biodiesel from soybean, which reached Policy Act through to 2010, and was 2 billion litres. The United States of expanded to include biodiesel. Biodiesel America is also devoting significant producers who use agricultural feedstocks resources towards developing and are eligible for a tax credit of US$1.00 per implementing next-generation biofuel gallon, while producers of waste-grease technologies. biodiesel can receive a credit of 50 cents A range of policies are currently being per gallon. Several states also offer some implemented to promote bioenergy, form of excise tax exemptions. VEETC is including the Energy Policy Act of 2005, applied to biofuels regardless of their the Energy Independence and Security country of origin. However, a 54 cents/ Act of 2007, the 2002 Farm Bill and the gallon and 2.5 percent ad valorem tariff is Biomass Research and Development Act imposed on imported ethanol. of 2000. Several of these affect liquid The Energy Policy Act of 2005 biofuels for transport. introduced quantitative targets for Financial incentives to biofuels began renewable fuels. Indeed, the Renewable during the Carter Administration with Fuels Standard (RFS), established by the the 1978 Energy Tax Act, following the Act, mandated that all motor petrol sold oil price shocks of the 1970s. The Act in the United States of America must provided an excise tax exemption for have reached a renewable fuel content of alcohol fuel blends at 100 percent of the 7.5 billion gallons (1 gallon = 3.785 litres) petrol tax, which at the time was 4 cents by 2012; after 2012, the percentage per gallon. More recently, the American content was to be maintained at the Jobs Creation Act of 2004 introduced level of 2012. Several states have also

incentives or penalties are among the Bioenergy research and development most widely used instruments and can has generally been aimed at developing dramatically affect the competitiveness of technologies for improving conversion biofuels vis-à-vis other energy sources and efficiency, identifying sustainable feedstock thus their commercial viability. The United and developing cost-effective conversion States of America was among the first of the methods for advanced fuels. Current OECD countries to implement biofuel tax patterns of funding in developed countries exemptions with the 1978 Energy Tax Act, suggest that an increasing proportion of following the oil price shocks of the 1970s. public research and development funding is The Act provided an excise tax exemption directed towards second-generation biofuels, for alcohol fuel blends. In 2004, the tax in particular cellulosic ethanol and biomass- exemption was replaced by an income tax derived alternatives to petroleum-based credit for producers. Other countries have diesel. since implemented different forms of excise tax exemptions. Economic costs of biofuel policies Research and development Most biofuel-producing countries conduct or The Global Subsidies Initiative (Steenblik, fund research and development at various 2007) has prepared estimates of subsidies stages of the biofuel production process, to the biofuel sector in selected OECD ranging from agronomy to combustion. economies, presented in Table 6. These BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 31

implemented, or plan to implement, their In terms of grants, the 2007 Energy own renewable fuels standards. Independence and Security Act authorized The 2005 Act also continued funding US$500 million annually for the fiscal years for the Biomass Program, providing more 2008–15 for the production of advanced than US$500 million to promote use biofuels with at least an 80 percent of biotechnology and other advanced reduction in life-cycle greenhouse gas processes to make biofuels from cellulosic emissions relative to current fuels. feedstocks cost-competitive with petrol It likewise foresaw a US$200 million and diesel, to increase the production of grant programme for the installation of bioproducts that reduce the use of fossil refuelling infrastructure for ethanol-85. fuels in manufacturing facilities and to The 2002 Farm Bill had included several demonstrate the commercial application provisions to promote the development of integrated bio-refineries that use of bio-refineries, to provide incentives cellulosic feedstocks to produce liquid to feedstock producers and to realize transport fuels, high-value chemicals, education programmes for farmers, local electricity and heat. authorities and civil society promoting The Energy Independence and the benefits of biofuel production and Security Act of 2007 established more utilization. The 2007 Farm Bill, voted by ambitious quantitative targets, stipulating Congress in May 2008, reduced the tax a volume for 2008 of 9 billion gallons of credit for maize-based ethanol from 51 to renewable fuels and a phased increase 45 cents per gallon and introduced a tax to 36 billion gallons by 2022. Of the credit of US$1.01 per gallon for cellulose- latter, 21 billion gallons should be covered based ethanol. by advanced biofuels (of which 16 billion from cellulosic biofuels and 5 billion from undifferentiated advanced Sources: based on GBEP, 2007, and information biofuels). from USDA, 2008a, and RFA, 2008.

estimates give a rough idea of the production, which is calculated separately in magnitude of transfers supporting biofuels the TSE for agriculture. in the countries covered, although they Table 6 confirms that biofuel subsidies probably tend to underestimate the total are already relatively costly for taxpayers value of investment incentives, for which and consumers in the OECD economies, information is difficult to obtain. The with United States processors and growers estimates do not consider potential market- receiving support worth just over US$6 billion distorting impacts of the different policies. per year, and those in the EU receiving almost The total support estimates (TSE) calculate US$5 billion per year. The table also provides the total value of all government support estimates of the share of TSE that varies to the biofuels industry including, among according to the level of production. This others, consumption mandates, tax credits, provides an indication of how the total would import barriers, investment subsidies and change with increasing output, such as that general support to the sector such as public implied by the consumption targets in place research investment. They are analogous in the EU and the United States of America. to the TSE calculated for agriculture by EU ethanol subsidies are almost completely the OECD. As such, they include measures variable with output and so would increase deemed to be directly tied to production in line with mandated increases in output. levels and less-distorting supports that are The table also suggests that OECD biofuel not directly linked to output. They do not subsidies are likely to become much larger as include support to agricultural feedstock mandated consumption increases. 32 THE STATE OF FOOD AND AGRICULTURE 2008

BOX 5 Biofuel policies in the European Union

Over the past decade, the production and States to set national indicative use of biofuels has increased substantially targets for the share of biofuels, in in the European Union (EU). In 2007, line with reference percentages of the 9 billion litres of biofuel were produced, Directive, although it leaves them free dominated by biodiesel (6 billion litres). to choose a strategy to achieve these The sector has undergone very rapid targets. growth, with Germany accounting for The second pillar is Directive 2003/96/EC, more than half of EU biodiesel production. which allows for the application of tax The main feedstock used is rapeseed incentives for biofuels. Taxation not (about 80 percent), with sunflower oil and being within the sphere of action of the soybean oil making up most of the rest. European Community, each Member The EU industry has been slower to invest State can decide on a level of taxation in ethanol production, which totalled for fossil fuels and biofuels. However, almost 3 billion litres in 2007. The main these tax exemptions are considered as ethanol feedstocks are sugar beet and environmental state aid and therefore cereals. their implementation by Member States EU biofuel legislation consists of three requires authorization from the European main Directives. The first pillar is Directive Commission in order to avoid undue 2003/30/EC for promotion of a biofuels distortions of competition. market in the EU. To encourage biofuel The third pillar of the EU biofuel use, in competition with less costly fossil legislation concerns environmental fuels, the Directive sets a voluntary specifications for fuels indicated in “reference target” of 2 percent biofuel Directive 98/70/EC amended by Directive consumption (on the basis of energy 2003/17/EC. The Directive contains a content) by 2005 and 5.75 percent by 5 percent limit on ethanol blending for 31 December 2010. It obliges Member environmental reasons. The Commission

TABLE 6 Total support estimates for biofuels in selected OECD economies in 2006

OECD economy ETHANOL BIODIESEL TOTAL LIQUID BIOFUELS

TSE Variable share1 TSE Variable share1 TSE Variable share1

(Billion US$) (Percentage) (Billion US$) (Percentage) (Billion US$) (Percentage)

United States 5.8 93 0.53 89 6.33 93 of America2 European 1.6 98 3.1 90 4.7 93 Union3

Canada4 0.15 70 0.013 55 0.163 69

Australia5 0.043 60 0.032 75 0.075 66

Switzerland 0.001 94 0.009 94 0.01 94

Total 7.6 93 3.7 90 11.3 92

1 The percentage of support that varies with increasing production or consumption, and includes market-price support, production payments or tax credits, fuel-excise tax credits and subsidies to variable inputs. 2 Lower bound of the reported range. 3 Total for the 25 Member States of the European Union in 2006. 4 Provisional estimates. 5 Data refer to the fiscal year beginning 1 July 2006. Sources: Steenblik, 2007; Koplow, 2007; Quirke, Steenblik and Warner, 2008. BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 33

has proposed an amendment that includes Communication An energy policy for a 10 percent blend for ethanol. Europe, endorsed a binding target of a Bioenergy support has also been 20 percent share of renewable energies in introduced as part of the Common overall EU energy consumption by 2020, Agricultural Policy, especially following as well as a 10 percent binding minimum its reform in 2003. By cutting the link target for the share of biofuels in overall between payments made to farmers and EU petrol and diesel consumption for the specific crops they produce, the reform transport by 2020. The latter target is allowed them to take advantage of new subject to production being sustainable, market opportunities such as those offered second-generation biofuels becoming by biofuels. A special aid of €45 per hectare commercially available and the fuel- is available for energy crops grown on non- quality Directive being amended to allow set-aside land (traditional food crop areas). for adequate levels of blending (Council In addition, while farmers cannot cultivate of the European Union, 2007). A proposal food crops on set-aside land, they can use for a renewable energy Directive including this land for non-food crops, including both these targets and sustainability biofuels, and are eligible to receive criteria for biofuels was put forward compensatory payments per hectare. by the European Commission to the Support to bioenergy comes also from Council and the European Parliament on the new EU rural development policy, 23 January 2008. which includes measures to support renewable energies, such as grants and capital costs for setting up biomass production. In March 2007, the European Sources: based on GBEP, 2007, and information Council, based on the Commission’s from the Web site of the European Commission.

To provide some perspective on the are affected, whether or not they produce relative importance of these biofuel biofuels. The mandates, subsidies and subsidies, Table 7 shows them on a per-litre incentives being implemented by various basis. Ethanol subsidies range from about countries have created a major new source US$0.30 to US$1.00 per litre, while the range of demand for agricultural commodities. of biodiesel subsidies is wider. The table As a consequence, the historic linkages reveals that although some countries’ total between agriculture and the energy sector support expenditures are relatively modest, are becoming stronger and are changing in they can be substantial on a per-litre basis. character. Biofuel policies have important Again, the variable portion of support implications for farm output and incomes, provides an indication of the scope for commodity prices and food availability, increases in expenditures as output grows, returns to land and other resources, rural although some subsidies are budget-limited, employment and energy markets. especially at the state or provincial levels. An individual farmer will produce feedstock for biofuels if the net revenue he or she earns is greater than for alternative Economic viability of biofuels crops or uses. The decision-making process for a biofuel crop is the same as for any The biofuel policies discussed above are other crop. Farmers choose what to produce shaping the global agricultural economy in on the basis of expected net revenues ways that may have unintended consequences and perceptions of risk and may use for the countries implementing the policies formal models, experience, tradition or a and for the rest of the world. All countries combination of the three in making their 34 THE STATE OF FOOD AND AGRICULTURE 2008

choice. The calculus will differ from farm to Budgeting models can be used to evaluate farm and season to season, depending on the the financial performance of biofuel prevailing market and agronomic conditions. processing firms. Tiffany and Eidman (2003) Within the prevailing policy and market calculated the performance of a dry-mill context, the price a farmer receives for ethanol plant based on a range of maize a biofuel crop depends primarily on the prices, ethanol prices, prices of co-products, energy potential of the crop, conversion natural gas prices and interest rates relative costs, transportation costs and the value of to alternative investments. This model found co-products. As discussed in Chapter 2, crops that ethanol plants had experienced great differ in their physical energy potential, volatility in net returns over the preceding which is a function of biomass feedstock decade and that net returns were highly yields per hectare and the efficiency with sensitive to changes in price for maize, which the feedstock is converted to biofuels. ethanol and natural gas. These price changes, Yields vary from crop to crop, depending on together with variations in ethanol yields, cultivars, agronomic practices, soil quality could thus have a marked effect on net and weather. margins for ethanol plants. Global average crop yields for first- Yu and Tao (2008) provide a simulation of generation ethanol feedstocks range from three ethanol projects in different regions 1.3 tonnes per hectare for sweet sorghum of China based on different feedstocks: to 65 tonnes for sugar cane (see Table 2 on cassava, wheat and maize. They took into page 16). Similarly, conversion efficiency consideration the variability of feedstock and ranges from 70 litres of ethanol per tonne petroleum prices and calculated the expected for sugar cane to 430 litres for rice. In terms net present value (NPV) and internal rate of land intensity (litres/hectare), sugar beet of return (IRR) of investments of the three and sugar cane are the most productive projects under a range of price conditions. first-generation crops. Economic efficiency They found that the cassava project had a may differ markedly, however, because the positive expected NPV and an IRR exceeding costs of production vary widely by crop and 12 percent under most scenarios and thus location. was likely to be economically competitive,

TABLE 7 Approximate average and variable rates of support per litre of biofuel in selected OECD economies

OECD economy ETHANOL BIODIESEL

Average Variable Average Variable

(US$/litre)1 (US$/litre)1 (US$/litre)1 (US$/litre)1

Federal: 0.15 Federal: 0.26 United States of America2 0.28 0.55 States: 0.00–0.26 States: 0.00–26

European Union3 1.00 0.00–0.90 0.70 0.00–0.50

Federal: up to 0.10 Federal: up to 0.20 Canada4 0.40 0.20 Provinces: 0.00–0.20 Provinces: 0.00–0.14

Australia5 0.36 0.32 0.35 0.32

Switzerland6 0.60 0.60 1.00 0.60–2.00

Notes: 1 Values (except in the case of the United States of America and Australia) are rounded to the nearest US$0.10. 2 Lower bound of reported range. Some payments are budget-limited. 3 Refers to support provided by Member States. 4 Provisional estimates; includes incentives introduced on 1 April 2008. Federal and most provincial supports are budget-limited. 5 Data refer to the fiscal year beginning 1 July 2006. Payments are not budget-limited. 6 Range for biodiesel depends on source and type of feedstock. Some payments are limited to a fixed number of litres. Source: Steenblik, 2007, p. 39. BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 35

FIGURE 9 Biofuel production costs in selected countries, 2004 and 2007

US$/litre 2.0

1.5

1.0

0.5

0.0

-0.5

2004 2007 2004 2007 2004 2007 2004 2007 2004 2007 2004 2007

Ethanol ■ Sugar cane Ethanol ■ Sugar beet Ethanol ■ Maize Ethanol ■ Wheat Biodiesel ■ Rapeseed Biodiesel ■ Soybean Brazil European Union United States European Union European Union Brazil of America

Feedstock costs Processing costs Energy costs

Co-product value Net costs, total Fossil fuel price*

*Net price of petrol or diesel in national markets. Source: OECD–FAO, 2008. although with a 25 percent probability production in Brazil are negligible because of less favourable returns. The maize and bagasse, the major co-product of sugar- wheat projects had very low or negative cane processing, is burned for fuel. In NPVs and thus would not be economically contrast, European and United States viable without subsidies. The relatively processors typically pay for fuel, but sell poor performance of the wheat and maize co-products from the ethanol and biodiesel projects was attributable primarily to higher production processes, usually for animal feedstock costs, which exceeded 75 percent feed. of total production costs. After subtracting the value of co-products, OECD–FAO (2008) estimated average the resulting net production costs, on a biofuel production costs in selected countries per litre basis, are also lowest for Brazilian for alternative feedstocks, shown in Figure 9. sugar-cane ethanol – the only biofuel that Costs are broken down by feedstock, is consistently priced below its fossil-fuel processing and energy costs. The value of equivalent. Brazilian biodiesel from soybean co-products is deducted and net costs are and United States ethanol from maize have indicated in the chart by a square dot. The the next lowest net production costs, but in market price of the nearest equivalent fossil both cases costs exceed the market price of fuel (petrol or diesel) is indicated for each fossil fuels. European biodiesel production fuel by a green bar. costs are more than double those for By far the lowest total costs are for Brazilian ethanol, reflecting higher feedstock Brazilian sugar-cane ethanol. In all cases for and processing costs. Feedstock costs for which data are reported, the commodity maize, wheat, rapeseed and soybean rose feedstock accounts for the largest share sharply between 2004 and 2007, and future of total costs. Energy costs for ethanol profitability will depend on how they 36 THE STATE OF FOOD AND AGRICULTURE 2008

FIGURE 10 Breakeven prices for crude oil and selected feedstocks in 2005

Price of crude oil (US$/barrel)

140 Price of oil, May 2008 120

100

80 Mixed feedstocks, Europe 60 Price of oil, January 2005 Maize, USA 40 Sugar cane, Brazil 20

0

Source: based on data from FAO, 2006a.

continue to evolve in relation to petroleum relative feedstock and crude oil prices for prices. the economic viability of the system. For A 2006 FAO study calculated the points example, at a crude oil price of US$60.00/ at which ethanol from various feedstocks barrel, ethanol processors could pay up and farming production systems would to US$79.52/tonne for maize and remain be competitive with fossil fuels, based on profitable. Similarly, at crude oil prices of average feedstock prices prior to 2006 US$100.00/barrel, processors could pay up to (FAO, 2006a) (see Figure 10). The findings US$162.98/tonne. The solid black line traces reveal a wide variation in the ability of out the various parity prices or breakeven different systems to deliver biofuels on points for ethanol-based maize in the United an economically competitive basis and States of America. At price combinations are consistent with those of the OECD in located above and to the left of the parity that Brazilian sugar cane was found to be price line, maize ethanol is profitable; at competitive at much lower crude oil prices lower crude oil prices or higher maize prices than other feedstocks and production (combinations below and to the right of the locations. Based on maize prices prior to solid line), maize ethanol is not profitable. 2006, United States maize ethanol was Similar analyses could be performed for found to be competitive at crude oil prices of other feedstocks and production locations. around US$58/barrel, but it is important to The results would differ according to the note that this breakeven point will change technical efficiency of feedstock production as feedstock prices change. Indeed, sharp and biofuel conversion in the particular rises in maize prices (partly due to demand setting. The parity price line for lower-cost for biofuels) and reductions in sugar prices producers would intersect the vertical axis at since this analysis was conducted suggest a lower point. The slope of the parity price that the competitive advantage of Brazilian line would depend on the ease with which sugar-cane ethanol over United States maize producers can expand feedstock production ethanol may have widened. and biofuel processing in response to Tyner and Taheripour (2007) took the price changes. A country’s parity price line dynamic nature of commodity prices into could also shift over time in response to account and calculated the breakeven technological progress, improvements in points – without tax credits and incentives – infrastructure or institutional innovations. for various combinations of maize-based Tyner and Taheripour (2007) also took ethanol and crude oil prices in the into consideration the influence of policy United States of America, given existing interventions on economic viability. They technologies (Figure 11). Their analysis of a estimated that the United States renewable single feedstock reveals the importance of fuel standard, tax credits and tariff barriers BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 37

FIGURE 11 Breakeven prices for maize and crude oil in the United States of America

Price of crude oil (US$/barrel) 140

120 MAIZE ETHANOL is profitable 100

80

60 MAIZE ETHANOL is not profitable 40

20

0 50 100 150 200 250 Price of maize (US$/tonne)

Parity prices without subsidies

Source: based on Tyner and Taheripour, 2007.

(see Box 4 on United States biofuel policies) points show that the relative maize/crude oil represent a combined subsidy of about prices generally lie to the right of the black US$1.60/bushel (US$63.00/tonne) for maize line, indicating that the maize price is higher used in ethanol production. Figure 12 than the breakeven point for ethanol on an shows the breakeven prices for maize at energy basis and that United States maize various crude oil prices, both on the basis ethanol is not competitive with fossil fuels of the energy content of ethanol and also without subsidies. The price pairs typically including the value of the existing subsidies. lie between the two lines, indicating that The red line takes into account the value subsidies are often, but not always, enough of United States mandates and subsidies to make maize ethanol competitive. for ethanol. This line is below and to the Looking at the data over time reveals a right of the black line, indicating that for stepwise relationship, in which the price of a given crude oil price, ethanol processors crude oil seems to pull up maize prices as can pay a higher price for maize and remain ethanol production expands. Before mid- profitable. The value of the mandates and 2004, crude oil prices were so low that maize subsidies raises the breakeven price for could not compete as an ethanol feedstock maize by about US$63.00/tonne for any even with the available subsidies. Crude oil given level of petroleum prices. As shown prices began to rise in mid-2004, at a time above, for a crude oil price of US$60/barrel, when maize prices were still quite low. By maize ethanol would be competitive on an early 2005, crude prices had exceeded US$60/ energy basis as long as the market price for barrel and maize was almost competitive maize remained below US$79.52/tonne, but even without subsidies. The United States the subsidies enable processors to pay up to Energy Policy Act of 2005 established the US$142.51/tonne and still remain profitable. Renewable Fuel Standard starting at 4 billion Figure 13 superimposes observed monthly gallons in 2006 and rising to 7.5 billion in maize and crude oil prices from June 2003 2012. A rush of ethanol plant construction through April 2008 on top of Tyner and ensued, and the demand for maize as a Taheripour’s parity price lines. The data feedstock for ethanol expanded rapidly. 38 THE STATE OF FOOD AND AGRICULTURE 2008

FIGURE 12 Breakeven prices for maize and crude oil with and without subsidies

Price of crude oil (US$/barrel) 140

120 MAIZE ETHANOL is profitable 100 Profitable 80 with subsidies

60 MAIZE ETHANOL is not profitable 40

20

0 50 100 150 200 250 Price of maize (US$/tonne)

Parity prices without subsidies Parity prices with subsidies

Source: based on Tyner and Taheripour, 2007.

FIGURE 13 Maize and crude oil breakeven prices and observed prices, 2003–08

Price of crude oil (US$/barrel) 140

120 April 2008

October 2007 100

80 March 2006 February 2007 60

40 April 2004 July 2003 20

0 50 100 150 200 250 Price of maize (US$/tonne)

Parity prices Parity prices Monthly prices without subsidies with subsidies since 2003

Sources: adapted from Tyner and Taheripour, 2007. Crude oil prices: Brent crude, Chicago Board of Trade (US$/barrel). Maize prices: US Yellow No. 2, Chicago Board of Trade (US$/tonne). Prices downloaded from the Commodity Research Bureau Web site (http://www.crbtrader.com/crbindex/) on 10 June 2008. BIOFUELS: PROSPECTS, RISKS AND OPPORTUNITIES 39

The price of maize rose steadily throughout same general pattern in relation to 2006, partly in response to ethanol demand, oil prices as in the case of maize. Sugar although other market factors were also prices, in contrast, have been declining involved, while the price of crude oil in recent years, serving to enhance the remained close to US$60/barrel. During this profitability of sugar cane as an ethanol period, the competitiveness of maize as an feedstock. ethanol feedstock fell sharply even with the subsidies, and many ethanol plants began to operate at a loss. Crude oil prices began Key messages of the chapter rising sharply again in mid-2007, reaching US$135/barrel by mid-2008. Maize thus • Liquid biofuels such as bioethanol regained its competitiveness, albeit with and biodiesel compete directly with subsidies, after mid-2007.7 Biofuel policies petroleum-based petrol and diesel. themselves influence the price of agricultural Because energy markets are large commodities and hence partially determine compared with agricultural markets, their competitiveness as feedstocks for energy prices will tend to drive the biofuel production. The role of policies in prices of biofuels and their agricultural shaping biofuel markets is explored more feedstocks. fully in Chapter 4. • Biofuel feedstocks also compete with The analysis suggests that, given current other agricultural crops for productive technology, United States maize ethanol resources; therefore energy prices will can rarely and only briefly achieve market tend to affect prices of all agricultural viability before the price of maize is bid commodities that rely on the same up to the point that it again becomes resource base. For the same reason, uncompetitive as a feedstock. Current producing biofuels from non-food subsidies and trade barriers offset part of crops will not necessarily eliminate this disadvantage, but do not guarantee competition between food and fuel. competitiveness. • For given technologies, the The analysis also illustrates the close competitiveness of biofuels will depend link between crude oil prices and prices of on the relative prices of agricultural agricultural feedstocks. The pattern revealed feedstocks and fossil fuels. The is consistent with the argument presented relationship will differ among crops, at the beginning of this chapter that, countries, locations and technologies because energy markets are large relative used in biofuel production. to agricultural markets, crude oil prices will • With the important exception of ethanol drive agricultural prices. It further underlines produced from sugar cane in Brazil, the role played by government support which has the lowest production costs policies in shaping the relationship between among the large-scale biofuel-producing prices in the two sectors. countries, biofuels are not generally While similar breakeven point analysis competitive with fossil fuels without has not been conducted for other biofuel subsidies, even at current high crude oil feedstocks and other countries, an prices. However, competitiveness can examination of the crude oil–commodity change in line with changes in feedstock price pairs suggests that similar patterns and energy prices and developments hold for most feedstocks. Figure 14 shows in technology. Competitiveness is also the monthly price pairs for petroleum and influenced directly by policies. rapeseed, palm oil, soybean and sugar. With • Biofuel development in OECD countries the exception of sugar, they exhibit the has been promoted and supported by governments through a wide array of

7 An additional factor stimulating ethanol demand in the policy instruments; a growing number of United States of America has been the ban in California – developing countries are also beginning effective from January 2004 – on the use of methyl tertiary to introduce policies to promote butyl ether (MBTE). MBTE is a petrol additive used to biofuels. Common policy instruments improve the clean burning of engines, but with suspected adverse impacts on water quality, that can be replaced by include mandated blending of biofuels ethanol. with petroleum-based fuels, subsidies 40 THE STATE OF FOOD AND AGRICULTURE 2008

FIGURE 14 Price relationships between crude oil and other biofuel feedstocks, 2003–08

RAPESEED PALM OIL

Price of crude oil (US$/barrel)* Price of crude oil (US$/barrel)* 120 120 100 100 80 80 60 60 40 40 20 20 0 0 0 150 300 450 600 750 900 0 200 400 600 800 1 000 1 200 1 400 Price of rapeseed (US$/tonne) Price of palm oil (US$/tonne)

SOYBEAN SUGAR

Price of crude oil (US$/barrel)* Price of crude oil (US$/barrel)*

120 120 100 100 80 80 60 60 40 40 20 20 0 0 0 100 200 300 400 500 600 0 50 100 150 200 250 300 350 400 450 Price of soybeans (US$/tonne) Price of sugar (US$/tonne)

* Monthly prices since 2003. Sources: Crude oil prices: Brent crude, Chicago Board of Trade (US$ per barrel), downloaded from the Commodity Research Bureau Web site (http://www.crbtrader.com/crbindex/) on 10 June 2008. Commodity prices from FAO international commodity price database.

to production and distribution, and tax products. Although seemingly effective incentives. Tariff barriers for biofuels in supporting domestic farmers, the are also widely used to protect domestic effectiveness of biofuel policies in producers. These policies have decisively reaching the climate-change and energy- affected the profitability of biofuel security objectives is coming under production, which in many cases would increasing scrutiny. otherwise not have been commercially • In most cases, these policies have been viable. costly and have tended to introduce new • The main drivers behind government distortions to already severely distorted support for the sector have been and protected agricultural markets – at concerns over climate change and the domestic and global levels. This energy security as well as the desire has not tended to favour an efficient to support the farm sector through international production pattern for increased demand for agricultural biofuels and biofuel feedstocks.